Question

Instructions:

You are the Chief Financial Officer (CFO) of a firm that is being sued for damages it caused. It is the end of your fiscal year, and you are trying to determine the appropriate treatment of this matter. Your boss, the Chief Executive Officer (CEO) acknowledges (privately) that your firm is responsible for the damages and that the judgment will be made against your firm. Your legal counsel estimates that the penalty levied by the court will be in the range of $2 million to $6 million, with a most likely amount of $4 million. The CEO's posture on the matter is that because of the wide variance in the range of possible outcomes (i.e. penalties levied) that the best thing to do is to simply wait until the case is settled (next year), and record at that time the actual damages assessed by the court.

Answer the following questions:

What are some possible reasons that the CEO may hold his viewpoint?

What should be your response to the CEO?

Do you think it is necessary to make an accrual for an estimated amount of the assessment or settlement? If so, what amount do you think is appropriate?

Explain. Would your answer to any of the above questions be different if the financials are being prepared under IFRS instead of U.S. GAAP?

Answer 1

What are some possible reasons that the CEO may hold his viewpoint?

The CEO might hold this view since he thinks that the probability of the occurrence of the damages is not precise. Secondly, he may have the opinion that the real penalty levied by the court is not predictable and might present the balance sheet with a chance of error should the estimate of the loss differ from that of the court.

What should be your response to the CEO?

The boss attests to the fact that most likely, the case will be made against our company. The company’s legal counsel also estimates the penalty to amount to $4 million. This scenario will cost the company the said amount beyond a reasonable doubt. My advice to the CEO would, therefore, be to record the contingent liability because of its high probability and since we can reasonably estimate the amount.

Do you think it is necessary to make an accrual for an estimated amount of the assessment or settlement? If so, what amount do you think is appropriate? Explain.

It is necessary to make an accrual for the estimated amount of the settlement. The most appropriate amount would be $4 million since this is the figure predicted by the company’s legal counsel. The reason why it would be important to record it is that the possibility of the contingent damage is most probable and the amount can be estimated. This loss can be recorded as a loss or expense in the income statement or as a liability on the balance sheet.

Would your answer to any of the above questions be different if the financials are being prepared under IFRS instead of U.S. GAAP?

If the statements were being prepared under IFRS instead of U.S. GAAP, the only difference would be in the definition of ‘probable.' Under IFRS, this term is defined as ‘more likely than not’ to occur. This would have a meaning that the probability of the contingent liability occurring would have a higher probability than the probability of not occurring. The assessment of this term would be subject to the firm’s judgment. IFRS states that the midpoint of the range of the contingent liability should be used in a case where no amount in the range is a better estimate. In this case, the amount anticipated ($4 million) falls at the midpoint of the range.

Conclusion:It is of great importance to precisely classify the contingent liability in the best way possible. Also, it is good to know where to record it, according to its classification. When it is very probable, it’s reflected in the financial statements by deducting the net income and increasing the liability. Secondly, if they can't be estimated, a footnote should be made to reveal this fact in the statements. If the loss is not likely at all, nothing should be recorded in the financial statements.